You Can't Be Serious

I admit to being surprised by Cyprus. Oh, not the banking crisis or the sovereign debt crisis or the fact that its banks were eight times larger than the country itself or even the fact that the banks were bloated with Greek debt that had been written down. I wrote about all that a long time ago. What surprised me was that all the above was apparently a surprise to European leaders.

While there is much to not like about what European leaders have done since the onset of their crisis some five years ago, they have demonstrated a prodigious ability to kick, poke, and massage the can down the road, to defuse crisis after crisis, and to indefinitely postpone the inevitable. They have demonstrated a remarkable ability to spend taxpayers’ and others’ money in order to keep Europe and the euro more or less in one piece. At every step they have been keenly intent on maintaining trust in the system. That they have been successful in keeping a majority of citizens in favor of the Eurozone and the euro, even in countries forced to endure serious austerity, must be recognized.

However, the shock in Cyprus reveals an absolute lack of preparedness in dealing with a problem that had festered for several years. By now it should be no surprise to anyone that sovereign nations can default, that banks can go bankrupt under the weight of defaulted sovereign debt, and that banks can be too large for some countries to bail out. That a clear and consistent response to Cyprus should have been worked out in the halls of Brussels and the ECB seems so, well, reasonable. Clearly, the large depositors in Cypriot banks, the majority of whom were Russian (according to Financial Times reports) thought the Eurozone had a plan. In fact, the apparent assumption, bordering on religious faith, that Eurozone leaders would not allow depositors in Cypriot banks to lose one euro, is almost touching. This snafu is going to have repercussions that spread far beyond this tiny island nation. Let’s look at a few of the implications.

When we woke up to the Eurozone pronouncement that all depositors in Cypriot banks, no matter the size of their deposits, would take a loss, my reaction was somewhat akin to John McEnroe shouting, “You can’t be serious!” to a line judge whose call he infamously questioned.

While there was no official deposit guarantee in place in Europe, the implicit guarantee was €100,000, a number that had become all but sacred during the recent banking crisis. To wake up and find that European leaders not only did not consider this protection to be implicit but also planned to demand losses from all depositors, was quite the shock. I think this may have been the single worst “call” by European leaders since the beginning of the crisis in 2008.

Let’s look first at what actually transpired. Cypriot banks held deposits of roughly €68 billion, four times the size of the total national GDP, while the total size of the banks was roughly eight times GDP. The “Troika” seemed to feel that Cyprus needed €17 billion in bailout money to be able to handle the crisis. But after finding hundreds of billions for Greece and Spain, they were only able to offer tiny Cyprus €10 billion (€10 billion is the equivalent of offering the US $8 trillion, give or take a few euros, just to keep it in perspective), and demanded that depositors in Cypriot banks be levied for most of the remaining €7 billion. They offered a formula by which small depositors would lose somewhat less than 10% and large depositors somewhat more (the actual number varied day by day).

The Cypriot parliament totally rejected the Eurozone proposal. Not one vote was cast for the deal. And when you look at the numbers, as any politician does, you can see why. This is an island of 1.1 million men, women, and children. There are (were) 370,000 bank accounts, with 360,000 of those containing fewer than 100,000 euros (per Dennis Gartman). In the recent presidential elections in Cyprus, there were 445,009 voters and a voter turn-out rate of 81%. Thus, a huge majority of voters had accounts with less than €100,000 in them. Call me cynical, but I think any politician could figure out which side of this fence to land on.

It now appears that “only” €5.8 billion is needed for the bailout, so the 10,000 or so accounts holding more than €100,000 will be docked an average of €580,000. “The tottering banks hold 68 billion euros ($88 billion) in deposits, including 38 billion ($49 billion) in accounts of more than 100,000 euros – enormous sums for an island of 1.1 million people, which could never sustain such a big financial system on its own.” (NBC World News).

On the surface it looks like large depositors will lose about 15%. And if the Financial Times is right (and the betting line is heavily on their side), a significant majority of that money is Russian. Much of the remainder is tax-haven money (more on that later). “Not so bad,” you might think; “things could be worse.”

Well, actually they are worse. Some EZ officials suggest that the losses of large depositors could range up to 40%, and the Cypriots themselves suggest 30%. That is because if you are a Greek bank with a Cyprus branch your deposits are exempt from the levy. The logic behind that decision is just too arcane to explain in a brief letter that prides itself on rational explanations. Which is another way of saying that I actually couldn’t understand it myself. But then, I’m just a country boy from West Texas, not a European financial wizard.

Things keep spiraling down in the Eurozone. One of the founding principles of the Eurozone was that a euro anywhere within the zone would be as good as one anywhere else. Euros would flow freely. All for one and one for all.

Except that now euros in Cypriot banks are no longer equal. Not only are they going to be “taxed” (or whatever euphemism they end up choosing – they’re still debating that one – but if it were your account you might call it theft), but deposits will be subject to capital controls. Reports coming out of Europe this morning suggest that banks in Cyprus will stay closed until at least Thursday. It is not clear when you will actually be able to take your money and leave the sunny shores of Cyprus.

Cypriot banks will remain closed until Thursday, the government announced on Monday night, as President Nicos Anastasiades acknowledged that the country had come “a breath away from economic collapse” before its last-minute bailout. Speaking after he agreed a €10bn international rescue that includes the restructuring of the island’s two biggest lenders with losses for bigger depositors, Mr Anastasiades also said capital controls would be imposed but as a “very temporary measure that will be gradually relaxed”. (The Financial Times)

We will eventually learn what time frame a Cypriot politician has in mind when he says “temporary.” And Mr. Anastasiades may have been speaking optimistically to the press. Other Cypriot politicians were rather less sanguine.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.